Sunday, April 20, 2014

Institutional Investing in Uncertain Times


Negatives: Parallels to WWI and II, Inefficient redistribution through wages and taxes, Disappointing earnings, Global economies to lag market declines, Faulty analysis.

Positives: Private sector growth, Nuveen purchase, Boston Marathon, Boom ahead.

Instruments of Success: Time Horizon Portfolios


For three of the great religions of the world this was an important week of cherished celebrations. As each of these institutions needs to look after its flock now and in the future, financial capital investment for all should be thought of as a group of coordinated portfolios. In my work with various non-profit organizations I have been an advocate of at least four such portfolios. 

The first is the expected next two year expenditure pool or the operating subsidy beyond current donations and earned revenues. 

The next portfolio is the replenishment portfolio which is designed to replenish the operating subsidy over a relatively short period of five years. It is this pool that is at most risk to a market decline as it may not have enough time to recover from its former peak.(Depending on the likely term of current leadership there may be greater sensitivity to leaving the organization as strong as when the current team came into its responsibilities.) 

The third portfolio or legacy pool is designed to provide funding for the foreseeable future of at least the next leadership team. They need to be concerned for paying for the physical and human upkeep of existing facilities. The legacy portfolio can recover from periodic market declines. 

The fourth portfolio, or endowment pool, is to recognize that institutions will need to provide services beyond their current framework which may well mean a major desired expansion. The endowment portfolio needs to provide the necessary capital for expansion and thus must grow faster than its surrounding economy. Often, this can most readily be accomplished by taking advantage of periodic opportunities offered in declining markets.

Addressing the needs of the four portfolios is what I attempt to do for various long-term focused institutions and wealthy families which want to provide funding for three or more generations. Today my focus is on what changes may be needed for the second or replenishment portfolio. If the other three are well structured, current problems and opportunities do not require much in the way of changes.

The issue today is the appropriate weightings of the negatives and positives that are lurking just below the horizon that most investment commentary is focused.

Negatives discussed

I have often commented that if one scratches the wrist of an analyst, a historian will bleed. In that vein, the work being conducted at Caltech and elsewhere shows some work that passes for thinking and judgment is essentially memory. Not only because of my history lessons from the US Marine Corps, but my study of financial and therefore political history I am struck with the increasing parallels with the political actions that led up to World War I and II. In each case initially the eventual protagonists did not seek armed conflict. They were indoctrinated by their general staffs on von Clausewitz’s principle that war is another way to accomplish policy goals. Both sides felt that they were under economic attack from the other side and the integrity of their promises to their allies was threatened. In both cases the US was intent on not getting militarily involved and applied economic sanctions to slow down or prevent further expansions of the other side. In each case the US strategy failed. I am very hopeful that the parallels do not complete a triple disaster.

If external problems are not enough, the US is in the process of hollowing itself out by adopting a very inefficient way to redistribute wealth through increases in minimum wages in the reported economy and changes in tax rates and regulations. The issue is very simple from a geometric point of view. Those currently in power look at a pie chart of wealth and want to change how it is allocated. The real way to put more money in people’s hands is to grow the pie to larger sizes. If we are going to focus on redrawing the slices, our attention must be focused on the trade-offs between the slices. Unfortunately, those with less capital are more at risk to diminished purchasing power due to government sponsored inflation and the relative destruction of small local businesses. On the other hand if the pie is growing through providing more goods and services to both internal and export markets there will be more income at all levels for those who wanted to work.

So far, the reported earning season has been disappointing. This is particularly true when compared to a very robust fourth quarter in 2013. A careful analysis of operating margins (pre net interest income) is showing a minor contraction in many cases. As we progress through the year the quarterly comparisons with those of 2013 will probably look less healthy. Outside of absolutely needed capital expenditures in the US, an expansion in spending here is not expected unless the results of the 2014 election and the prospects for the 2016 election look favorable to both corporate and individual investors. Even in the case where domestic production is cheaper and more efficient than outside the US, there is little headway in bringing more work and capital back into the US.

The financial community is always looking for an easy way to express an abstract thought. We love numbers because we can arbitrage against these numerical trends by purchasing below trend and selling and/or shorting above trend. This approach can last for a long time, way beyond its analytical usefulness. I am very concerned that in two cases these mathematical extrapolations are going to be increasingly found wanting. The first is the very popular CAPE (Cyclically Adjusted Price to Earnings ratio) developed by Robert Shiller of Yale University. In his model he uses the reported ten rolling year’s earnings per share compared with current prices to determine whether a market is under or over priced. As an analyst one of my frustrations is that the quality of reported earnings is evolving. Accounting rules have been changed to favor the use of financial statements for the benefit of lenders not investors. Further, almost every year there are substantive modifications in federal and state taxes. The plain truth is that long past results are not much use for investment these days by strategic or ordinary buyers. I suggest that these simplistic calculations can lead investors to believing that there is not a valuation risk in today’s markets. 

The second questionable measure is a purported measure of risk, called from its symbol, VIX. S&P reported that various ETFs that were meant to go up when volatility increased, did not. As a matter of fact the inverse instruments did. More importantly, we believe that risk of large losses is not effectively measured by volatility. Over the last twenty or more trading days numerous biotech and Internet-oriented retailers suffered significant price declines that they had not experienced before. This suggests to me risk of large losses is more likely a function on the rate of past price gains and excessive current valuations.


When one strips out the impact of governments at various levels, there is considerable evidence that the private sector is somewhat haltingly growing in many countries. Interestingly, the UK, with a somewhat more orthodox economic policy, is leading the way. This is very much worth watching for global investors as the FTSE 100 price chart appears to have created a triple top going back to the 2000 year. If it were to decisively go through the 2000 peak, a chart pattern would be created that the market technicians would believe becomes a base for a massive expansion.

One sign that a long-term focused financial institution believes that there will be more money flowing into financial management is the purchase of Nuveen by TIAA-CREF. The intention is to keep the acquisition separate and under present management. This is important because the buyer recognizes the value of the existing management and projects that the individual and institutional markets will grow faster than the general stock market. With its resources TIAA-CREF could have hired a bunch of people to do the same jobs as the Nuveen people do. 

On Monday the Boston Marathon will be run. A year ago it was disrupted by terrorists’ bombs. Like New York after the 9/11/2001 attacks, Boston is coming back showing the resilience of the American people just as we showed once our political leaders fumbled us into the two world wars.

In looking beyond a period when the markets lead our economies down, there is an increasing belief that a major boom is ahead for us. The applications of technology and energy production and use will change the structure of how we live and I suspect, invest.

Applying Time Horizon Portfolios

While I will be happy to discuss specifics with our readers, let me briefly outline my suggestions.

Operating Portfolio - An Operating Portfolio to cover at least two years of planned expenditures should be kept in high quality short-term instruments of limited duration.

Replenishment Portfolio - A Replenishment Portfolio, which normally would look like a sound Balanced fund, reduces its risk portion by going into somewhat limited in duration, high quality Fixed-Income with high quality, (probably Large Cap) equities in equal proportions. If the market gives an opportunity to buy high quality securities at significantly lower than today’s prices, I would be willing to dramatically raise the stock portion.

Legacy Portfolio - Outside of a small trading reserve, a Legacy Portfolio should be equity focused. This could include some high yield bonds or even bankruptcy paper, but not at today’s prices. Entrepreneurial companies that are dealing with expanding markets would find a natural home in this portfolio.

Endowment Portfolio - An Endowment Portfolio should be focused on companies that are currently disruptive and smart. They are currently disruptive by dramatically changing pricing due to technology. Many small companies may fit within this portfolio.

In our investment practice we intend to fill these four Time Horizon Portfolios with mutual funds and similar SMAs.

Question of the week:

Which negatives and positives do you agree/disagree with? Please let me know.    
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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, April 13, 2014

Shallow Investment Pitches Lead to Strike Outs

Book value may not be valuable...Changes in reported earnings per share is not growth...Putting into practice fund selection...Where are we now?


I am focusing today on the kinds of “elevator comments” that one hears in the lift (to use the British expression) designed to lead to a purchase of particular stocks or funds. Often the pitcher is pushing growth or value securities based on published corporate numbers and current prices. Some of these pitch people earnestly believe that given a simple numerical relationship and current prices is all that an investor needs to know to make a good decision. These are very much the kinds of people that Benjamin Graham and David Dodd warned about in their seminal tome Security Analysis. At this particular time in the market investors are weighing what to do following what has been successful tactics of buying on dips. Or in contrast, using any rally as a good time to lighten up their portfolios. They should judge whether they are happy with the quality of the supporting research.

Book Value may not be valuable

Occasionally one hears that a stock or a portfolio manager should buy a stock or a fund that is selling at prices below stated book value. In our consumer society nothing sells more easily than saying it is available at a discount. All too often what is being said is that the current price is below the last published book value, without any discussion of what comprises book value. Book value, as most of readers know is a single per share number that encompasses the net worth of the company as stated on the balance sheet. The accountant’s job in preparing a balance sheet is to look at the historic costs of the assets purchased reduced by periodic deductions for the use of the assets and to portray the known debts owed to determine the net worth. 

One of the first things that Professor David Dodd taught me was to reconstitute the balance sheet for current investment purposes. This would exclude all elements of goodwill, raise questions as to the immediate value of elements of inventory, machinery, buildings among other items. Further, future liabilities for taxes and pensions (including tenure when appropriate) would quickly reduce the quick sale value of the company. In periods of rapid price changes and accelerating technological changes old assets may lose value very abruptly. In today’s world the costs of bank branches is probably not worth the prices reflected on most bank balance sheets. This is not always the case. One of my successful investments was in a chain of local cigar stores. In Manhattan, where I grew up, in almost every neighborhood  “high street” to use the British term for retail commercial thoroughfares, these cigar stores had prime corner store locations. As tastes were changing, smoking cigars were in a steep decline so were the operating earnings of the company which did not have much debt outstanding. All of the local shops were in long-term leased space.

When the company finally recognized the inevitable collapse of its business, its prime real estate locations were of considerable value so that when the company liquidated the shareholders were richly rewarded. Many current investors are hoping that will be the future pattern for Sears and Kmart. When a stock that has a reasonable following of qualified analysts is selling at a steep discount to book value or for banks in terms of net tangible value, I believe that the current market price for the common shares is probably more representative of value than book or tangible value. On the surface things sell in relation to where they are currently perceived. However, because liquidation is a long process discounts of 25% from book value is not unreasonable for a negotiated multiple year liquidation. Thus, book value to me is the beginning of the conversation in the elevator not the end.

Changes in reported earnings per share is not growth

Besides selling at a discount for book value the other main “elevator pitch” is growth. “This year earnings will be up 15% and more next year, with that kind of growth the stock should sell for at least 10% higher than today’s price,” is the way the story goes. Again a competent analyst will look at the composition of the expected growth to determine the value that should be ascribed to the shares.

In a recent communication to Deutsche Bank’s US fund holders it showed the composition of its expected 2014 earnings growth for US, European and Japanese companies. In the US, they expect a 9% gain with 3% coming from buybacks and no profit margin improvement; for European stocks they are looking for earnings gains of 12%; and 13% for Japanese companies. In each case they are looking for very low buybacks and a 3.4% margin expansion in Europe and 1.5% in Japan. The analyst in me would not give any growth credit for buying back shares which benefits management more than long-term shareholders who would prefer reinvestment into expanding businesses. Thus I would look to a possible growth increment for US stocks, if their estimates hold up, of only 6%. Considering that both European central bankers and those in Japan are trying to introduce more price inflation into their cyclically depressed economies I do not value at face value the expected margin improvement in Europe and Japan. These brief analyses do not show any increase in the level of risk undertaken, but as Jamie Dimon has said and proven, risk is inherent in their business and I would suggest in all businesses to some extent. Further if the economies are expanding risk appetite will likely expand as well. For JP Morgan effective risk management is a top priority I am not sure that it is an equal concern in most companies.

On a longer-term basis earnings growth will be dependent on whether the companies are serving continuously growing markets and the pace of disruption. There are at least two disrupting trends that will change the dynamics of future earning progress. 

The first is the concept of walk up business for bank branch locations. Banks are redesigning their branches into smaller footprints  which will be more sales stores offering assistance with automated devices may be a way to defeat the newer financial organizations which have no branches. A number of formerly retail clothing locations are increasingly relying on the web as their main sales outlet. Both of these trends have significant implications for mall operators. 

The second trend (which will take a somewhat longer time to be important) is the global energy deflation in terms of costs. Not only is this based on the increased use of natural gas but also more productive sourcing of oil and possibly newer forms of energy. This may well be recognized now as utilities are the only major equity sector that is up on a year to date basis, +8.9%. Because much of utility earnings are regulated the lower cost of energy will lead to savings for their larger customers and possibly to their retail customers.

Putting all into fund selection practice

Again I have two suggestions. The first is to address the accounting issue head on. I am sure that there are a number of analysts who are skilled at reconstituting balance sheets and income statements. One that we have used is Charles Dreifus of Royce Associates, a subsidiary of Legg Mason* who regularly takes deep dives into stocks for both his Small Cap and Multi-cap funds. These are funds that are organized for long-term investors.
* Owned by me personally and/or in a private financial services fund I manage

A second approach which we have practiced for some of our managed accounts in building a portfolio of mutual funds is dependent upon a willingness to accept different performance leadership at different times during the cycle. In its simplest form funds are picked because of their value orientation the way a strategic buyer would look at the underlying holdings, for example secular growth funds that utilize the cyclicality of growth around a positive trend, and funds that are focusing on disruptive products, services, and sales procedures. The art form is modifying the weight of the three components based on client risk appetite.

Where are we now?

As regular readers of these posts know I have been concerned about a forthcoming peak market followed by a significant decline. Up until mid March I did not see the elements of a final parabolic rise that I believed was a precondition for a major decline. I was wrong looking at the market in terms of major aggregates; e.g., Dow Jones Industrial Average rather than sectors and subsectors for incredible performances for major over-valuations. There are ten Biotech companies whose stocks are selling 1000 times current sales. Internet retailers are selling at 5.7 times their current stock prices whereas the S&P 500 is selling at 1.6 times current prices according to a recent column by Jason Zweig in The Wall Street Journal. I am using price/sales as a measure to avoid dealing with questionable accounting or the absence of current profits. This last week we have seen a measurable decline in these extended issues. Only future history will tell us whether these price movements are sufficient to declare a peak in the entire market. If we have experienced a top, the fall is likely to be on the order of 15-20% for the general market, not the supposed once in generational drop of 50% or more as we saw in 2008. The key to watch is whether the subsequent recovery picks up volume and speculators who think of themselves as investors start discounting rosy projections for the latter half of this decade. When and if this does happen it will meet the enthusiasm requirement for a peak.

Question for the week:
How enthusiastic are you on your accounting proficiency?

Sunday, April 6, 2014

Signals or Static Perspective?


I can’t avoid thinking like a US Marine this Sunday. We just received the notice of the memorial service for General Carl Mundy who was the 30th Commandant of the USMC and my fellow classmate in Basic Officers Class. As Marines we learned to observe every detail about our surroundings and most particularly about our enemies. As in the battle for investment survival, which requires a degree of investment success, we also need to observe all elements that are visible and look for those that are beneath the surface. We know that each day or week could hold the clues to future actions. The difficulty that I face is separating meaningful signals from day-to-day statistical static. Carl did these well both in battles and in his post active duty service and I will try to emulate his skills.

First quarter 2014 mixed messages

Extrapolating the large gains achieved by equity funds, particularly the Small Capitalization funds with significant holdings first in technology and second in financial services, one would have been prepared for a continuation of these trends. On the surface there were very few surprises in the first quarter based on the financial headlines. Yet the natural order of performance was quite different. The leading performing large asset class was commodities, not across the board but a number of industrial and agricultural goods, in addition to gold and energy had positive results. Under normal circumstances this kind of price behavior would indicate inflation and significant shortages of supplies. But this was not the case as the central bankers were complaining about the lack of inflation to provide economic stimulus that the fiscal authorities were not.

Focusing on the next best asset class for some, which was taxable bonds, the best performing fund group was those funds that had mostly “A” rated corporate bonds in their portfolios with an average gain of +3.94%. They were followed by funds with somewhat lower credit rated bonds (BBB) which gained +3.32%. Somewhat surprising in a period of expansion, the third best bond category was the High Yield or junk bond funds up +2.75%. They normally lead in bullish times as in the last twelve months with gains of + 7.32%. What may be happening is that the wave of acquisitions that were being financed through high yield paper may have created supply bigger than demand. Further, those with a historical perspective may have felt that the yield spread versus the poor performing treasuries was too narrow. All of these results suggest to me that the fixed income and commodity investor was acting cautiously, but was questioning the value of the US government’s paper as well as the reality of inflation production.

The equity funds also sent out mixed and not very strong signals. Of the 31 equity investment objective classifications tracked by my old firm, now known as Lipper, Inc., four produced slightly negative results and five positive results. The losers were hurt by disenchantment with growth regardless of size (Small-Cap Growth -0.47%  and Large-Cap Growth -0.11%). The gainers were led by two traditional bets against the future lower value to the US dollar and/or increased inflation. The average Precious Metals fund was up +12.28% but still down -29.29% for the trailing twelve months. The second best was the Real Estate funds +8.13%. From a macro point of view the most surprising performance was from the average Utility funds +6.69%. This result was clearly better than any bond category. Often utilities are viewed as bond substitutes. The fourth best was Health/Biotech at 6.69%. The fifth best was the Mid-Cap Value funds up +3.14%. The other twenty two equity funds had gains below 3% or under the results for both bonds and commodities.

The ends of March

As indicated in last week’s post I detected a significant change in equity leadership. This change is better defined when one examines the month of March performance. The four worst performers were the Precious Metals funds -7.82% giving up some of their recovery, Health/Biotech funds -5.30%, Large Cap growth -3.22% (all of the growth fund categories declined in March). A good further explanation for their declines was the fall of -2.67%
in the Science & Technology classification.  Science and Technology has driven a good bit of the Growth funds' performance. Clearly the old war horses of the 2013 leadership in healthcare and technology were no longer producing bigger dreams for their owners. The new leaders seem to be very specific in terms of their own merits even though there appears to be greater attraction to value-oriented portfolios (see April observations below). British funds seem to be reading from the same playbook being used in the US.

If one is following the script of an aging bull market the switch to larger caps that have perceived value safety nets beneath them makes sense. However, if the next market collapse proves to be spectacular, we will need to have sudden, sharp, parabolic price explosion on the upside. That kind of performance is normally needed for a 50% decline. Without such a runup, the next decline is more likely to be in the neighborhood of  25% which is not enough to dislodge sound long-term investment portfolios.

Early April flows and ratings pluses

Being indebted to my old firm for flow data,  I can see some interesting cross trends if I parse the data carefully. The traditional equity mutual fund had net estimated inflows for the week ending on Wednesday of $2.2 billion; however $1.6 billion were non-domestic stock funds. This would indicate that only about $600 million was betting along with the Administration that good things are in the offering for the US economy. Some of the money leaving the US may be going to Europe on the basis that Moody’s is regularly raising western European credit ratings, that business is improving and the price/earnings discounts to comparable US stocks makes them attractive. I suspect a smaller piece is going out to buy Asian stocks that are recovering somewhat from their prior fall. In term of investment objectives, the traditional mutual funds buyer put the bulk of their net money in Large Cap core funds which category included index and closet index funds. Some of that money probably came from the $429 million net outflows from the Large Cap growth funds. These shifts were aligned with our prior observations.

What are most interesting are the flows into the ETFs. Their assets are considerably smaller than the traditional mutual funds, but they managed to put more money, $3.2 billion into their equity funds of which $2.5 billion were in non-domestic portfolios. The domestic fund investment benefited from a $941 million flow into a large S&P 500 index fund which appears to be a “parking lot” type of investment, rather than a long-term commitment.

Why focus on mutual funds?

First, mutual funds around the world, according to the Investment Company Institute (ICI) have $30 trillion dollars under management. In many markets they are the most transparent institutional investor. Often some of the 76,200 funds are managed in the same fashion as the other institutional accounts in their shops. Thus an analysis of what mutual funds are doing gives one useful intelligence as to what is happening in both the institutional mind set as well as the general investing public.

Second, I spend most of my working hours focused on the proper selection of funds for clients as well as our extensive charitable activities. Third we eat our own cooking, as we invest in these funds for my family along with a private fund that invests in mutual fund management company stocks and other financial services providers.

My question for the week is:

How prepared is your thinking for the next market decline? Please let me know, for General Mundy would expect me to look at any moving object that was somewhat visible.

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.